Saturday, February 4, 2012

Understanding Austrian Economics, Part 1

Understanding Founder Carl Menger's Contributions to the Field

Austrian economics owes its name to the historic fact that it was founded and first elaborated by three Austrians—Carl Menger (1840–1921), Friedrich von Wieser (1851–1926), and Eugen von Böhm-Bawerk (1851–1914). The latter two built upon Menger, though Böhm-Bawerk, in particular, made important additional contributions.

Menger’s great work, translated into English (but not until seventy-nine years later!) under the title of Principles of Economics, was published in 1871. (Carl Menger, Principles of Economics, trans. James Dingwall and Bert F. Hoselitz (New York: New York University Press, 1981).

In the same year, by coincidence, W. Stanley Jevons in England published his Theory of Political Economy. Both authors independently developed the concept now known as “marginal utility.” (Menger never used the term. Jevons called it “final degree of utility.” It was Wieser who first employed the German term Grenz-nutzen, which translates as “marginal utility.”)

But as few American or British economists read German in the original, it was years before the real extent of the revolution begun by Menger was realized outside of German-speaking countries. For it was Menger, by recognizing most fully the implications of the marginal-utility concept, who opened up new paths and, so to speak, turned the old classical economics upside-down.

Menger insists throughout his work that value is essentially subjective, and that therefore economics must be in the main a subjective science. Goods have no inherent value in themselves. They are valued because they help to satisfy some human want or need. A given quantity or unit of a certain good will satisfy a man’s most intense desire or need. He may also want a second, third, or fourth increment. But after each unit consumed or employed, his desire or need for a further unit of that good may be less intense, and may finally become completely satisfied.

It follows that each increment of that good at his disposal will have a reduced value to him. But as no unit of the total available quantity of that good can have a greater value in exchange than any other (of the same quality), it follows further that no other unit will be worth more in the market than the “final” unit of the supply. Thus in a given community the exchange value of a given increment of each good will be determined by the relation between its total available quantity and the intensity of the human need or want that it fills.

So far this may seem like little more than a refinement on the old classical doctrine that value and price are determined by supply and demand. It seems merely to state that doctrine in subjective rather than objective terms. But then Menger comes to point out some of its implications. The values of goods are mutually interdependent. Bread is valued because it meets a direct consumption need. Flour is valued because it is needed to bake bread. Wheat is valued because it is needed to produce flour. Plows, seed, land, and labor are valued because they are necessary to produce wheat, and so on.

Values are also interdependent because, for example, if one raw material necessary in combination for the production of a final product is missing, that lack reduces the usefulness and value of the other raw materials needed.

Goods wanted and ready for direct use or consumption are called by Menger “goods of the first order.” Raw materials and other factors necessary to produce these are called “goods of the second order.” Materials, machinery, labor, and other factors needed in turn to produce these goods of the second order are called goods of the third order, and so on. These goods of the second, third, and other “higher” orders are valued because of the consumption goods that they produce.

Thus while the classical Ricardian doctrine held that the “normal” value of consumption goods was determined by their “cost of production,” the Austrian doctrine holds that the “cost of production” itself is ultimately determined by the value of consumption goods.

These two doctrines can be partly reconciled in the statement that though what a good has cost to produce cannot directly determine its value, what it will cost to produce determines how much of it will continue to be made. It is the limit that cost of production puts upon the total quantity of a good produced that determines its marginal value and therefore its market price. Thus there is a constant tendency for marginal cost of production and market price to equal each other, though not because the first directly determines the second.

Opportunity Costs

Something should be said also about the sharp distinction between the Ricardian and the Austrian concept of “cost.” The Ricardian (and the modern businessman) thinks of cost as a money outlay. But the Austrian economist has a much wider concept, what economists now call “opportunity” costs, or “forgone opportunity” costs. Such costs exist, of course, not only in business but in all our decisions and actions in life. The cost of learning French in any given period is to forgo learning German, or to learn less mathematics, or to give up some tennis or bridge, and so on.

Menger emphasizes the importance of time and the role of uncertainty in the whole productive process. He also points out that no single good, no matter how abundant, can maintain life and welfare, but that these depend upon the production of combinations of goods of different kinds in the proper proportions. And he points out, finally, that the process of production cannot be expected to go on at an adequate rate unless there is adequate protection of property.

The economic value of goods, to repeat, depends upon their respective quantities in relation to the human needs they meet. It does not necessarily depend upon the amount of labor expended in their production. To quote from Menger’s Principles of Economics: “Hence, if there were a society where all goods were available in amounts exceeding the requirements for them, there would be no economic goods nor any ‘wealth.’ . . . Hence we have the queer contradiction that a continuous increase of the objects of wealth would have, as a necessary final consequence, a diminution of wealth” (pp. 109–10).

(In other words, Menger pointed out more than a century ago a basic fallacy in the now-fashionable national income statistics.)

“The value of goods arises from their relationship to our needs, and is not inherent in the goods themselves . . . . Objectification of the value of goods, which is entirely subjective in nature, has nevertheless contributed very greatly to confusion about the basic principles of our science. . . . The importance that goods have for us and which we call value is merely imputed” (pp. 120–21, 139).

“There is no necessary and direct connection between the value of a good and whether, or in what quantities, labor and other goods of higher order were applied to its production. . . . Whether a diamond was found accidentally or was obtained from a diamond pit with the employment of a thousand days of labor is completely irrelevant for its value” (p. 146).

Menger goes on to discuss further how higher goods, including capital goods, get their value: “[I]t is evident that the value of goods of higher order is always and without exception determined by the prospective value of the goods of lower order in whose production they serve” (p. 150).

He outlines a theory of interest, but he leaves it vague. On page 156 of Principles of Economics he tells us: “[W]e have reached one of the most important truths of our science, the ‘productivity of capital.’” But he emphasizes that this productivity occurs only through the passage of time, and that therefore the market value of presently existing and available goods is at a “discount” compared with the expected value of equivalent goods in the future.

A Time-Preference Theory

This suggests that Menger leaned more toward a “time preference” than a “productivity” theory of interest, though the distinction between these theories was not sharpened and made explicit until the publication of Böhm-Bawerk’s Capital and Interest in 1884 and his Positive Theory of Capital in 1888. Böhm-Bawerk laid great emphasis upon the superior productivity of “roundabout” processes of production, and therefore (after a brilliant demolition of productivity theories of interest) ended by himself offering a theory of interest that combined productivity and time preference. Nearly all “Austrians” today, however, following the lead of Frank A. Fetter and later of Ludwig von Mises, support a pure time-preference theory.

To return to Menger: His Principles of Economics next presents a “theory of exchange.” In this he points out that men do not buy from or sell to or exchange with each other merely because of a “propensity of men to truck and barter,” as implied by Adam Smith, but because each man seeks to maximize his satisfactions by exchanging what he values less for what he values more. In this way the satisfaction of all is increased. Exchange is thus an integral part of the whole process of production. What is being produced is value. Menger’s whole theory of price, to repeat, is developed on the basis of “the subjective character of value.”

The final chapter of Menger’s Principles is on “The Theory of Money.” This does not explicitly discuss such subjects as interest rates or inflation, but deals solely with fundamentals, especially the origin and evolution of money. “Money is not the product of an agreement on the part of economizing men nor the product of legislative acts. No one invented it” (p. 262). It developed out of barter. Because it so seldom happened that A and B each had and was willing to offer exactly what the other wanted, triangular and indirect barter began to take place. Men first offered their specialized goods for more “marketable” goods more widely wanted, in the hope that they could exchange these, in turn, for the particular goods that they themselves wanted. As a result these more “saleable” goods became still more saleable because of this extra demand. The most saleable of all finally became “money.” Historically, all kinds of goods have served as money, though it later came down to coins of precise weights of copper, silver, or gold.

Money is not a “measure of value,” though it is legitimate to call it a measure of price. It is the only commodity in which all others can be evaluated without roundabout procedures. It is the most appropriate form in which people can save and store part of their wealth. The right of coinage has generally been left to governments, even though “they have so often and so greatly misused their power” (p. 283).

I may have seemed to devote a disproportionate amount of space to Menger, but the special contributions of Austrian economics can be most clearly realized, it seems to me, if we begin by dwelling in some detail on those of its originator.

Menger’s first important successor as an “Austrian” economist was Friedrich von Wieser, who, beginning in 1884, published several books elaborating, rounding out, and refining Menger’s theory of value, clarifying especially problems of cost, “imputation,” and distribution.

The next great successor was Eugen von Böhm-Bawerk, whose trailblazing contributions in Capital and Interest,in 1884, and the Positive Theory of Capital, in 1888, have already been referred to. In addition, Böhm-Bawerk wrote a brilliant demolition of Marx’s Das Kapital in 1896, in a comparatively short work first translated into English under the title Karl Marx and the Close of His System. In this essay Böhm-Bawerk exposed particularly the fallacies in Marx’s labor theory of value and his “exploitation” theories, which the latter had derived as a supposed corollary from errors of Ricardo. It should be emphasized that it was the analysis of Austrian economics that made Böhm’s refutation of Marx so conclusive. No refutation based on the assumptions of the old classical economics could have been as devastating.

Henry Hazlitt (1894-1993) was a noted economist, author, editor, reviewer, and columnist. His best-known books are Economics in One Lesson, The Failure of the “New Economics,” The Foundations of Morality, and What You should Know About Inflation